According to Boston University finance professor Allen Michel, when a company announces it's buying back stock, that stock tends to outperform the market by 2%-4% more than it otherwise would have over the ensuing six months.
But over the long term, multiple studies show that buybacks actually destroy shareholder value. CNBC pundit Jim Cramer cites the example of big banks that bought back shares in 2007-2008 -- just before their stocks fell off a cliff. Far from buy signals, Cramer calls buybacks "a false sign of health ... and often a waste of shareholders' money." Indeed, the Financial Times recently warned: "The implied returns over a period from buy-backs by big companies would have been laughed out of the boardroom if they had been proposed for investment in ... conventional projects."
So why run buybacks at all? According to FT, management can use them to goose per-share earnings, which helps CEOs earn bonuses based on "performance." Also, the investment banks that run buybacks earn income and fees from promoting them. But you and me? Unless the purchase price is less than the shares' intrinsic value, we miss out.
And we're about to miss out again.
Two bad buybacks
StreetInsider.com keeps a running tally of which companies are buying back stock, and how much they're spending. SI is too polite to accuse companies of wasting shareholders' money, of course -- but I'm not. With SI's help, I've uncovered two examples of popular stocks that I believe are squandering shareholder dollars on ill-timed buybacks...and one stock that isn't.
Chipotle Mexican Grill (NYSE: CMG )
First up, Chipotle Mexican Grill. When Chipotle missed on earnings last month, the stock sold off -- for all of one day. News that management was planning to buy back $100 million worth of shares, however, soon brought investors around, and sent the shares soaring once more. Personally, though, I had the opposite reaction. Sales and earnings growth of 24% looked like fine results to me. The problem at Chipotle, I thought, was that management was spending too much to buy back its own shares.
Consider: Chipotle may well meet Wall Street's 21% annual growth target. Indeed, the Street's been surprisingly accurate on its predictions so far, landing within a percentage point or two of Chipotle's actual earnings numbers. But that's just the problem. Twenty-one percent long-term growth, if accurate, doesn't justify the 58 times earnings multiple attached to Chipotle shares. It doesn't even justify the 47 times multiple to Chipotle's free cash flow.
Long story short, I love the burritos, I love the business -- but Chipotle's stock is just plain too expensive to justify a buyback.
Rentech (NYSE: RTK )
A more egregious instance of misuse of shareholder capital can be found at Rentech. A couple of months ago, I explained why subsidiary Rentech Nitrogen Partners (NYSE: RNF ) offered investors a better bargain than its parent company. While Rentech was beginning to show signs that it might become a viable business, Rentech Nitrogen was already a veritable cash machine.
Unfortunately, it seems Rentech management never read that column. Last month, the synfuel specialist announced a plan to spend $25 million buying shares. It wasn't buying its undervalued subsidiary, though, but its overvalued self. Here's why this is a problem: Burdened by $70 million in net debt, unprofitable, and free-cash-flow negative, Rentech needs all the cash it's got to keep its business going. It's in no position to waste money buying overvalued shares. Rentech's subsidiary, however, is not just profitable, but generates far more free cash flow than even its income statement suggests. Last year, reported income was $24.9 million, but Rentech Nitrogen produced cash profit in excess of $66 million.
Given my druthers, I know which stock I'd buy -- and indeed, I've publicly recommended Rentech Nitrogen over its parent company on Motley Fool CAPS. (It's outperformed both Rentech proper and the S&P 500 index since I recommended it, by the way.)
A better use of cash
Now, I don't like to end this column on a down note, and fortunately, I have spotted one company out there that's spending its shareholders' money prudently: data storage specialist VMware (NYSE: VMW ) . Just last week, VMware declared an intention to buy back $600 million worth of its stock between now and the end of next year. I think that's a fine idea.
Priced at 59 times earnings, VMware looks expensive -- but really it isn't. You see, VMware generates free cash at more than twice the rate it reports net income, and it's piled up a heaping helping of cash in its bank account already. Result: The enterprise value-to-free cash flow on this stock is only 21.6, comfortably below analysts' expected 24% growth rate.
I still believe that parent company EMC (NYSE: EMC ) offers a better bargain than VMware, mind you. I've publicly endorsed that one, too, and my pick is beating the market handily. But EMC's subsidiary is safe to own as well. Management's getting a good bargain on VMware shares -- and you can, too.
Looking for more great stocks priced at "buyable" prices? You're in luck, because we've just found five of them. Read all about it in the Fool's new -- and free! -- report: "5 Stocks The Motley Fool Owns -- And You Should Too."